With the Dow Jones Industrial Average and the Standard & Poor's 500 at all-time highs, and the Nasdaq Composite Index at highs not seen for more than a decade, stock investors have enjoyed the best year for performance since 2003. As we look to 2014, investors will be challenged with some of the most complex economic conditions in history.
Surprisingly, stocks tend to perform quite well in the year following a year with double-digit gains. Going back to 1975, stocks have had 10 years during which performance exceeded 10 percent, following a year of less than 10 percent gains. Of those 10 occurrences, seven, or 70 percent of the time, the following year also saw double-digit stock gains. In three instances, the second years’ performance was superior to the first, and in one case, from 1995 through 1999, stocks generated five consecutive years of double-digit gains.
Next year may be different, however. With the Fed beginning the tapering process — reducing its monthly bond purchases — it will be much more difficult for the economy to generate acceptable levels of GDP growth and sustained employment gains. The stimulus injected into the economy through the Fed’s bond-buying program has been a key driver for stock performance in 2013. With the expectation that the Fed will remove all stimulus by the end of 2014, stocks will not have this underlying foundation of support to drive strong gains. As a result, stock performance will be much more dependent on revenue and earnings growth rates that, to date, have been uninspiring to say the least.
Looking to other asset classes, we will see bonds, real estate and commodities suffer as interest rates on the long end of the yield curve increase. The Fed’s commitment to maintain a zero percent Fed funds rate at the short end of the curve was heralded this past week as a positive for the economy. However, the result of holding short rates at zero percent while long rates push higher will be a steepening yield curve. Bonds in particular tend to perform very poorly in environments with steep yield curves, with longer maturity bonds suffering the largest losses in value. Those investors dependent on current income generated from bond portfolios will find it difficult to maintain portfolio values in this environment.
Rising interest rates (rates have been held artificially low as a result of the Fed’s bond-buying program, and as this stimulus is removed, rates will rise), especially on the long end of the curve, will certainly hurt real estate values. Higher mortgage rates will mean lower affordability for those who can qualify, and fewer people will qualify. As rates rise, prices must come down to maintain equivalent affordability, at least for those who need a mortgage to purchase a home.
Rising interest rates do not help capitalization rates for real estate investors either, as returns must be evaluated in the context of a more expensive borrowing environment. Activity in the real estate market has been curtailed due to a lack of inventory, as many homeowners either have negative equity — they owe more than the home is worth, or have too little equity to be able to secure a mortgage on the next property they would purchase. The added 3.5 percent tax on all capital gains for individuals earning $200,000 or more, and couples earning $250,000 or more, as a result of Obamacare, will also hurt real estate, as those who are able to sell and who have a capital gain will have less to reinvest in the next property.
If we compare all of these major asset classes, stocks look to be the most attractive choice for the foreseeable future. Even in a rising interest rate environment, and even with some inflation, stocks should perform well relative to other asset classes, as long as rates do not rise too quickly, and as long as inflation does not spiral out of control. Inflation appears to be under control at present, and the Fed plans to taper slowly throughout 2014. If the economy can generate 2.5 percent to 3 percent growth in 2014, stocks should be able to generate reasonable revenue and earnings growth throughout the year, improving valuations and allowing stocks to perform reasonably well. However, we should not expect stocks to rise as they have in 2013.
Next year will likely be a stock picker’s market — investors will not be able to simply buy and hold the overall market and expect to generate double-digit returns. While anything is possible, conditions look to be challenging. If the Fed gets it even a little wrong, things could get ugly in a hurry. Volatility will likely be much higher, with more frequent corrections of larger magnitudes. Smaller investors will be much more likely to panic-sell in this kind of environment, exacerbating losses in times of corrections.
With this type of investing environment, it will be critical to have a well-reasoned financial and investment plan in place, with clearly defined objectives. Strong plans can assist investors in sticking with their investing program in times of uncertainty, preventing them from making emotion-based decisions. It has been a tough road back from the depths of the Great Recession. For investors who have taken great risk to achieve strong returns during 2013, the last thing they will want to do is to give back those gains in 2014.